Bill burns needed capital, and he needed a lot of it. The co-founder, president, and CEO of Minrad, a manufacturer of medical devices and pharmaceuticals based in Buffalo, was convinced he was on the verge of something big. Minrad's products--which include an anesthetic that can be inhaled rather than injected and a lighting system to help surgeons increase their accuracy--had the ability to make medical procedures quicker and safer for both patients and doctors.

Burns had landed several long-term contracts with pharmaceutical manufacturers and distributors around the world. Now the 11-year-old company, which generated about $3.5 million in sales in 2004, needed cash to expand its anesthetics plant in Bethlehem, Pa., and beef up its sales staff. Burns had already raised and burned through his most recent $3 million round of venture capital. But when he started fishing around for more, he found that VC investors had grown more risk averse than they had been in the past. Indeed, only 19% of venture financing was invested in start-up and early-stage companies in the third quarter of 2005, compared with 22% a year earlier, according to the National Venture Capital Association.

Then a pair of investors suggested that Burns forget the VCs and investigate a complex and relatively obscure financial vehicle known as a PIPE. PIPEs, or private investments in public equity, allow publicly traded companies--in most cases, small- and mid-cap firms that trade over the counter--to sell stock to high net worth investors at discounted prices. These days, most of those investors are hedge funds, which now boast more than $1 trillion in assets. Many of those funds are interested in investing in early-stage companies--and PIPEs are one of their preferred ways of doing so. Last year about $3 billion in PIPE investments was plowed into more than 300 companies with less than $5 million in annual sales, according to Michael Membrado, a New York City securities attorney who advises early-stage companies on such deals and has done extensive research on the topic.

Burns was intrigued. Of course, there was one immediate problem to address. Minrad was not a publicly traded company. And given the current state of the market, Burns doubted he would be able to stage an IPO anytime soon.

It turns out he didn't have to. Traditional IPOs get all the attention, but they're not the only way for private companies to tap public markets. Most of the companies that get funds through PIPEs go public by listing stock on the Over the Counter Bulletin Board, or by merging with defunct publicly traded companies, commonly referred to as shells. The payday is smaller than in a traditional public offering--but so are the costs and the headaches involved.

Burns liked the idea of gaining access to so much capital. He also liked the idea of wading slowly into the stock market.

Burns liked the idea of gaining access to so much capital. He also liked the idea of wading slowly into the stock market, rather than trying to go public right out of the box with an IPO on a major exchange. So in the spring of 2004, he and his financial advisers began hunting for a shell company. In December, Minrad merged with Technology Acquisition Corp., which was founded in the 1970s and had been idle for the past decade. After the merger was complete, Minrad took the shell's spot on the OTC Bulletin Board under a new ticker symbol, MNRD.OB, and Burns began to court PIPE investors.

During the next few months, with his investment bank playing matchmaker, Burns made 35 presentations to hedge fund managers and wealthy private investors from around the world. In May, two funds, Australia-based Rubicon and Northbrook, Ill.-based Crestview Capital Funds, stepped up to lead the deal and negotiate its terms. Several other hedge funds and individual investors signed on, and last June, just six months after taking Minrad public, Burns landed $11.3 million in financing. It had taken him eight years to raise the same amount from angel investors and venture capitalists.

Of course, landing PIPE financing is a lot more complicated and expensive than rounding up investments from angels and VCs. And Minrad's strategy isn't right for all business owners, especially those who don't plan to go public eventually. Pulling together the reverse merger and the PIPE deal cost some $550,000 in accounting and legal bills, on top of about $1 million in investment banking fees. And now that Minrad is publicly traded, Burns also has been forced to spend tens of thousands of dollars to comply with SEC regulations and the Sarbanes-Oxley Act.

PIPE investments also carry considerable risk for entrepreneurs. Unlike venture capital or angel investors, shareholders can sell their stock at any time. To make that less likely, Burns made it clear to potential investors that the value of Minrad's stock was likely to take off in 2007, when several new products, including a drug delivery system that will sedate surgery patients while keeping them alert and responsive, are scheduled to hit the market. "If investors didn't have a 2007 mentality, they moved away from the deal," he says. "It became a self-selecting process."

During the past year, the SEC has begun to scrutinize PIPE deals more closely, and the agency has charged one hedge fund manager with insider trading, alleging that she shorted the stock of one company before its PIPE. Burns covered his bases by choosing his investors carefully, relying heavily on referrals from his financial advisers, who spent months vetting hedge fund managers and individual investors to make sure they were trustworthy.

Now the pressure is on for Minrad's stock to perform well. In June and July, the company issued 11,260 shares of preferred stock to PIPE investors at an average discount of 43% to the price of its common stock, which was trading at $2. If the stock hits $5 per share and daily trading volume reaches 50,000 shares for 20 consecutive days, each preferred share will automatically convert into 500 shares of common stock. Until then, Minrad must pay quarterly 6% dividends in either cash or common stock to its PIPE investors. To sweeten the pot, the company also issued warrants that would allow PIPE investors to buy 2.8 million shares of common stock at $3.85 or less a share during the next three years. (At presstime, the stock was trading at about $2 per share.) 

Thanks to the PIPE infusion, Minrad has begun to expand its anesthetics plant and is on track to double its work force, to 150, by the end of 2006. In November, the company also launched a new and improved version of its SabreSource device, which cuts down on radiation exposure during surgery by using laser beams, instead of X-rays, to guide doctors.

That same month, Minrad graduated from the OTC Bulletin Board to the American Stock Exchange, where it now trades under the symbol BUF. Rather than pursuing another PIPE, Burns plans to make a traditional secondary stock offering in a few months. And he expects it to be much easier than an IPO. "We've taken it in ministeps," he says. "Now, when we go on a road show, people will focus on the business--not on whether we can make it as a public company."

PIPE Dreams

Last year, early-stage companies landed $3 billion in PIPE financing, much of it from hedge funds. Below, the top five sectors.

Sector Amt. Invested (in millions) No. of Companies
Telecommunications $371.7 39
Energy & Environmental Technology $265.9 32
Financial, Banking & Insurance Services $227.4 14
IT, Systems & Enterprise Software $204.5 34
Medical & Dental Equipment & Devices $199.5 37

Source: M.M. Membrado


To learn more about the rules governing PIPE financing, visit the small-business section of the SEC website, which features regular updates on new amendments to regulations, a Q&A page, and downloadable forms.